Why I Agree With (Some of) Friedrich Hayek

Why I agree with (some of) Friedrich HayekBy: George SorosApril 28, 2011 03:00 PM EDT

Friedrich Hayek is generally regarded as the apostle of a brand of economics which holdsthat the market will assure the optimal allocation of resources — as long as thegovernment doesn’t interfere. It is a formalized and mathematical theory, whose two mainpillars are the efficient market hypothesis and the theory of rational expectations.

This is usually called the Chicago School, and it dominates the teaching of economics inthe United States. I call it market fundamentalism.

I have an alternative interpretation — diametrically opposed to the efficient market hypothesisand rational expectations. It is built on the twin pillars of fallibility and reflexivity.

I firmly believe these principles are in accordance with Hayek’s ideas.

But we can’t both be right. If I am right, market fundamentalism is wrong. That means Imust be able to show some inconsistency in Hayek’s ideas, which is what I propose to do.

Let’s start with Hayek’s influence on the twin pillars of my interpretation. I was a student atthe London School of Economics in the late 1940s and read the great methodologicalcontroversy between Karl Popper and Hayek in Economica, the school’s periodical.

I considered myself a disciple of Popper. But here I was on Hayek’s side. He inveighedagainst what he called “scientism” — meaning the slavish imitation of Newtonian physics.Popper took the opposite position. He argued in favor of what he called the doctrine of theunity of science — that the same methods and criteria apply to all scientific disciplines.

I was drawn to this controversy by my interest in Popper. I had read his book, “OpenSociety and its Enemies,” in which he argued that the inconvertible truth is beyond thereach of the human intellect, and ideologies that claim to hold this truth are bound to befalse. Therefore, he argued, they can be imposed on society only by repressive methods.

This helped me see the similarity between the Nazi and communist regimes. Having livedthrough both in Hungary, it made a great impression.

This led me to Popper’s theory of scientific method. Popper claimed that scientific theoriescan never be verified — they can only be falsified. So their validity is provisional — theymust forever remain open to falsification by testing. This avoids all the problems ofneeding to prove scientific theories beyond any doubt and establishes the importance oftesting. Only theories that can be falsified qualify as scientific.

While I was admiring the elegance of Popper’s theory, I was also studying elementaryeconomics. I was struck by a contradiction between the theory of perfect competition,

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which postulated perfect knowledge, with Popper’s theory, which asserted that perfectknowledge was unattainable. The contradiction could be resolved by recognizing thateconomic theory cannot meet the standards of Newtonian physics.

That is why I sided with Hayek — who warned against the slavish imitation of naturalscience and took issue with Popper — who asserted the doctrine of unity of method.

Hayek argued that economic agents base their decisions on their interpretation of reality,not on reality — and the two are never the same.

That is what I call fallibility. Hayek also recognized that decisions based on an imperfectunderstanding of reality are bound to have unintended consequences. But Hayek and Idrew diametrically opposed inferences from this insight.

Hayek used it to extol the virtues of the invisible hand of the marketplace, which was theunintended consequence of economic agents pursuing their self-interest. I used it todemonstrate the inherent instability of financial markets.

In my theory of reflexivity I assert that the thinking of economic agents serves twofunctions. On the one hand, they try to understand reality; that is the cognitive function. Onthe other, they try to make an impact on the situation. That is the participating, ormanipulative, function.

The two functions connect reality and the participants’ perception of reality in oppositedirections. As long as the two functions work independently of each other they producedeterminate results. When they operate simultaneously they interfere with each other.That is the case not only in the financial markets but also in many other social situations.

I call the interference reflexivity. Reflexivity introduces an element of unquantifiableuncertainty into both the participants’ understanding and the actual course of events.

This two-way connection works as a feedback loop. The feedback is either positive ornegative. Positive feedback reinforces both the prevailing trend and the prevailing bias —and leads to a mispricing of financial assets. Negative feedback corrects the bias. At oneextreme lies equilibrium, at the other are the financial “bubbles.” These occur when themispricing goes too far and becomes unsustainable — boom is then followed by bust.

In the real world, positive and negative feedback are intermingled and the two extremesare rarely, if ever, reached. Thus the equilibrium postulated by the efficient markethypothesis turns out to be an extreme — with little relevance to reality.

Frank Knight was the first to identify the unquantifiable uncertainty inherent in financialmarkets. John Maynard Keynes and his followers elaborated his insight.

Classical economists, by contrast, sought to eliminate the uncertainty connected withreflexivity from their subject matter. Hayek was one of them.

The methodological debate in Economica took place in the context of the larger political


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controversy over the role of the state in the economy. Hayek was on one side, Keynes andsocialist planners on the other.

But Hayek subordinated his methodological arguments to his political bias. That is thesource of his inconsistency. In the Economica, he attacked scientism. But after World WarII, when the communist threat became more acute, he overcame his methodologicalqualms and became the apostle of market fundamentalism — with only a mild rebuke forthe excessive use of quantitative methods in his Nobel Prize acceptance speech.

Because he was fighting communism, a scientific theory that proved that marketparticipants pursuing their self-interest assure the optimum allocation of resources was tooconvenient for him to reject. But it was also too good to be true.

Human beings act on the basis of their imperfect understanding — and their decisionshave unintended consequences. That makes human affairs less predictable than naturalphenomenon. So Hayek was right in originally opposing scientism.

At the time of the Economica articles, Popper was between Hayek and the socialistplanners. He was just as opposed as Hayek to communism’s threat to individual liberty,but he advocated what he called piecemeal social engineering rather than laissez-faire.

Here I sided with Popper. But Popper and Hayek were not that far apart. I was influencedby both — and I also found fault with both.

By identifying Hayek’s inconsistency and political bias, I do not mean to demean him —but to improve our understanding of financial markets and other social phenomena. Weare all biased in one way or another and, with the help of reflexivity, our misconceptionsplay a major role in shaping the course of history.

Because perfection is unattainable, it makes all the difference how close we come tounderstanding reality. Recognizing that the efficient market hypothesis and the theory ofrational expectations are both a dead end would be a major step forward.

As in that earlier time, the political controversy on the role of the state in the economy israging today. But the standards of political discourse have greatly deteriorated. The twosides used to engage in illuminating arguments; now they hardly talk. That is why I was sopleased to accept this invitation to the Cato Institute.

As I see it, the two sides in the current dispute have each got hold of one half of the truth.which they proclaim to be the whole truth. It was the hard right that took the initiative byarguing that the government is the cause of all our difficulties; and the so-called left, in sofar as it exists, has been forced to defend the need for regulating the private sector andproviding government services.

Though I am often painted as the representative of the far left — and I am certainly notfree of political bias — I recognize that the other side is half right in claiming that thegovernment is wasteful and inefficient and ought to function better.

But I also continue to cling to the other half of the truth — namely that financial markets


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are inherently unstable and need to be regulated.

Above all, I am profoundly worried that those who proclaim half truths as the whole truth,whether they are from the left or the right, are endangering our open society.

Both Hayek and Popper, I believe, would share that concern. Those of us concerned withthe protection of individual liberty ought to work together to restore the standards ofpolitical discourse that used to enable our democracy to function better.

George Soros is the founder of the Open Society Foundations and author, of “The Crashof 2008 and What It Means: The New Paradigm for Financial Markets.” This is an excerptof a speech Soros is giving at Cato Institute on Tuesday. The event is being livestreamedat www.cato.org beginning at 4 p.m. Tuesday, and will be available on the site after.

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Why I Agree With (Some of) Friedrich Hayek